China Law Blog

Wikipedia defines a demand letter as a "letter stating a legal claim (usually drafted by a lawyer) which makes a demand for restitution or performance of some obligation, owing to the recipients' alleged breach of contract, or for a legal wrong." Typically, these letters conclude with the lawyer threatening to sue or the non-lawyer letter writer threatening to go his or her attorney.

Such letters have become so commonplace in the United States that they most of the time fail to instill much fear into or much action from their recipient. I know of some lawyers who no longer will write such letters, believing that US companies will not seriously discuss any settlement until sued. I know of a company that manufactures a somewhat dangerous product and it receives maybe 100 lawsuit threatening letters a year from around the world. Before I started representing this company, they would respond to every letter by seeking a quick out of court settlement. I convinced them to change their strategy to ignore every letter and that has saved my client hundreds of thousands of dollars. Of the 100 letters ignored, less than ten typically result in a law suit and of those ten, we typically settle nine of them for little to no more than the settlement would have been had we responded to the letter and not forced a lawsuit. These numbers are not exact, but they should give a flavor to the benefits of ignoring such letters.

China is different.

We have a much higher rate of success in China with our demand letters than we do just about anywhere else. Co-blogger Steve Dickinson and I have often marveled at how we so often achieve positive results by sending out demand letters to Chinese companies that owe our clients money. We always send these letters in Chinese, sometimes under our own firms letterhead and sometimes under the letterhead of one of our affiliated Chinese law firms (with their permission and cooperation, of course). Like a demand letter in the United States, we usually conclude by saying that if resolution is not reached within x days, we will commence a lawsuit.

Steve and I did not know exactly why we tend to have such a high success rate with these letters (nor, on one level did we really care). We talked about how in the US companies usually either throw such letters in the trash or just send it on to their lawyers who, typically just say something like, "let's see if these guys really have the guts and financial wherewithal to really sue...." In China, where letters are more uncommon and companies are not nearly as joined at the hip to their lawyers as in the United States, we thought such letters are viewed as more important, unusual, and serious.

Now I THINK I know why.

Two Columbia Law School professors, Benjamin Liebman and Curtis Milhaupt did a study, entitled, "Reputational Sanctions in China’s Securities Market (forthcoming in the Columbia Law Review.) where they posit that the avoidance of public humiliation is a big behavior inducer in China. And unlike in the United States where being sued is a legal matter, in China it is humiliating, as per an Economist magazine article:

Over the past 18 years, China has introduced rules against market manipulation, fraud and insider dealing, but enforcement remains patchy. The China Securities Regulatory Commission seems competent but overwhelmed. Sometimes it takes years to issue penalties after lengthy investigations—and along the way cases lose relevance.In the meantime, the exchanges have quietly begun to acquire authority. The power that they wield appears flimsy—the most serious penalty they can levy is a rebuke to firms and individuals through public notices. [emphasis added]

But it is remarkably effective in a country with a long history of punishment by humiliation—think of the cangue, a rectangular slab around the neck, in pre-Communist times and dunce caps in the Cultural Revolution. As a result of the culturally relevant and effective method of financial enforcement mechanism, Messrs Liebman and Milhaupt write that between 2001 and 2006 the exchanges publicly criticised 205 companies and almost 1,700 people. They looked at the share prices of the targeted firms both when they disclosed the conduct for which they were being criticised and when the criticism was published. The admissions typically preceded the rebukes, and in the few weeks that followed the firms’ share prices underperformed the Shanghai stockmarket by an average of up to 6% (see left-hand chart). After the criticism, there was a further lag of up to 3% on average (see right-hand chart).

Furthermore, after an entity goes on the government “black list” through public criticism and shaming,

[r]aising money through equity markets and banks became more costly, and sometimes impossible, for companies that had been criticised. Suppliers and customers also took a tougher line. Some people lost the right to be a director or senior manager, and suffered from pariah status in a country where there is little pity for failure. The criticisms were sometimes even a prelude to formal investigations by the regulatory authorities.

From a comparative law point of view, this study points out not only the vast differences between legal regimes that actually work for different markets but also highlights the relevance of culture in establishing them. In the United States, being sued, investigated and/or prosecuted is pretty much a legal matter; while in China, it is more than that. When someone gets sued, it is as if she has lost part of her integrity in the public eye. For example, a few years ago a Chinese friend of mine was sued by his boss down in Houston, he was extremely distressed and felt humiliated by the lawsuit even though he understood that lawsuits in the United States are as common as cheese burgers. Public shaming goes deeper into the psyche of the Chinese (in general terms) because of the fear of failure and the love and care of one’s “face.”

Unfortunately, however, we are finding (particularly recently with the downturn) that even threats of imminent humiliation do not work on Chinese companies that no longer exist or simply lack the funds to pay.